Credit where it’s due

The OTC market place is growing even faster than the exchange traded futures and options markets; and credit derivatives, which are intended to offer protection against credit events such as a failure to pay and bankruptcy, are the largest portion and fastest growing segment. According to the International Swaps and Derivatives Association (ISDA), the notional value of credit default swaps grew by 52% in the first six months of 2006 to $26 trillion from $17 trillion, and the annual growth from mid 2005 to mid 2006 was 109%.

This market historically has been the exclusive domain of Wall Street banks, but that seems to be changing, as derivatives exchanges including Eurex AG, CME and the Chicago Board Options Exchange (CBOE) begin offering exchange-traded versions of these OTC products.

“All the exchanges view the credit derivatives market as a big opportunity; all want a piece of it and all are working to come up [with] products to service that market,” says Richard H. Repetto, partner and senior research analyst at Sandler O'Neill & Partners L.P.

Eurex, the European derivatives exchange, began listing futures contracts based on the iTraxx indexes of European credit-default swaps in late March. The CBOE intends to list credit default options on individual companies and later will file for credit-default basket options. The CME Credit Index Event contracts reference 32 high volatility entities. Both exchanges expect to list the contracts in the second quarter, pending regulatory approval. But so far, few of the investment banks have traded the contracts.

ISDA has recently commissioned a study of exchange traded credit derivatives. “In commissioning an analysis of other trades on this process, our primary objective is to ensure that the integrity and transparency of the auction methodology is not adversely affected by the influence of additional products on the Final Price," notes an ISDA spokesperson in an e-mailed statement. But the problem is more likely the status quo. Former Fed Chairman Alan Greenspan, at a Futures industry event, expressed surprise at how credit derivatives currently trade. “I was shocked to find that credit derivatives speculation and clearing operated with 19th century technology,” Greenspan said, referring to trades being executed over the telephone and confirmed on paper. “There is great danger there,” he added.

“Historically, when asset classes move from over the phone to electronic, customers save in trading costs,” says Patrick J. O’Shaughnessy, equity analyst Morningstar Inc. “Investment banks have an interest in keeping the status quo. They are pretty much the only source for people to make these transactions currently.” He adds that there is some fear that the combined CME/CBOT would concentrate great pricing power in the hands of the gigantic exchange that could use its pricing power to push prices down. Further, he notes there is speculation that the investment banks, including Morgan Stanley, which is advising ICE in its competitive bid to acquire the CBOT, and Goldman Sachs, an ICE equity owner, are pushing the ICE bid because of concerns that a combined CME/CBOT would become a substantial threat in the OTC markets in general, and the credit derivatives market specifically.

And the CME clearly is intent on further establishing itself in the OTC markets, citing OTC initiatives such as FXMarketspace, Swapstream and Clearing 360 as the foundation of future growth. Post merger, the combined CME/CBOT would control both the long-term and short-term debt markets.

“They view this as a competitor, so I’m not expecting a lot of support from the dealer community,” says Joseph Levin, executive vice president of research at the CBOE. “OTC markets are opaque markets. It’s the purview of the few,” adding that with the addition of price transparency, centralized clearing and the elimination of counterparty risk, he expects the CBOE will draw new traders and eventually attract the investment banks.